Sunday, 9 March 2014

The Curious Case of Bitcoins - Part I


Bitcoin, a creation of a computer programmer under the pseudonym Satoshi Nakamoto is an immensely popular decentralized virtual currency. In this post we seek to present a brief overview of such currency and its legal classification. We will however discuss the issues in detail in subsequent posts.

Bitcoins are referred to as cryptocurrency. The system basically uses encryption to validate transactions as well as for the production of the currency. Unlike other currencies either real or digital, there is no central bank or other central controlling authority.  Bitcoin’s decentralized system depends purely on an algorithm to regulate the currency thereby excluding human involvement in the production or distribution of the currency.
Bitcoin’s popularity lies in the fact that it works on a peer-to-peer basis. Hence it eliminates the need of a third party which significantly lowers transaction costs. There is a common presumption that transactions relating to Bitcoins are anonymous. However, one must take into account that Bitcoin system records all transactions on a public ledger referred to as blockchain. The transactions are not completely anonymous but allow for the use of pseudonyms. The public ledger is part of a highly cost-efficient design. The public ledger addresses two major problems. Firstly, since each Bitcoin and each user is given a unique digital identity the risk of forgery or counterfeiting is mitigated. Secondly, the public ledger eliminates the need to include a third party to verify transactions since the public ledger itself verifies the transfer of Bitcoins to the seller from the buyer.

In general there are three modes in which Bitcoins can be procured.  Users can exchange conventional money to procure Bitcoins. Typically there is a 0.5 per cent or lower exchange fee in such transactions.  Bitcoins are sold at prices determined on the basis of supply and demand.  The price of Bitcoin is prone to severe volatility with prices fluctuating by a few hundred dollars within a month.

The second method of procuring Bitcoins is by accepting the same as exchange for sale of goods or services. The third method is called mining. Users solve a complex math problem to discover new Bitcoins. Typical home computers will generally not enjoy much success in solving the problem. It is so designed that Bitcoins will be discovered at a limited and predictable rate.

Bitcoins are immune from the monetary policy of the Central Bank of a country since neither its velocity (rate of exchange) or the amount of money is directly under the supervision of the bank determining monetary policy in a country.

Another unique feature is that only 21 million Bitcoins will ever be created. One Bitcoin can be divided up to 8 decimal places. When the maximum limit of Bitcoins are reached,   will be traded without addition in number of Bitcoins, the trades will be likely to be in fractions of Bitcoins such as transactions of 0.10 Bitcoins down to 0.000 000 01 BTC.

Commercial Advantages with Bitcoins
The use of Bitcoins has attained a fair amount of popularity. The widespread use may be attributed to the following:

1. Transaction costs are significantly reduced for electronic payment.
2. Transactions using Bitcoins provide a great amount of privacy and perhaps a complete protection from identity theft.
3.Immunity from inflation is another complex advantage over conventional currency. Once value stored in conventional currency is converted into Bitcoins, a reduction in relative value of conventional currency has no effect on value stored in Bitcoins.

Concerns with use of Bitcoins
The extent of regulation of Bitcoin remains unclear, especially in the Indian context.  In December last year, the RBI released a press note warning users of Virtual Currencies against Risk posed by such currencies including Bitcoins and litecoins. The regulation does not prohibit the use of Bitcoins, instead it declares that the creation of Bitcoins and their trading is not regulated under the auspices of the Central Bank or monetary authority.  The concerns highlighted in the press note are that

i.            Virtual Currency (VC) is stored in electronic form carried in electronic wallets. They therefore become vulnerable to hacking and loss of password.
ii.                  There is no established framework for consumer dispute redressal.
iii.                The value of VC has been subject to great volatility in the recent past.
iv.                VC may be used for illicit transactions.  Further, in view of the limited anonymity this could lead to unintentional breaches of the Anti Money Laundering and CFT(combating the financing of terrorism) regulations.

As a caveat the RBI has stated it is currently examining the issues associated with the usage, holding and trading of VCs under the extant legal and regulatory framework of the country, including Foreign Exchange and Payment Systems laws and regulations.”

Its concerns are well founded in the wake of instances of hacking of VC systems in specific Bitcoins since well known Bitcoin Exchanges like Mt. Gox and Bitfloor have been subject to hacking attacks resulting in great theft of Bitcoins.
Legal status of Bitcoins

Recently the United States District Court of Eastern District of Texas sought to define the term and stated that a bitcoin is an electronic form of currency unbacked by any real asset or without specie, such as a coin or precious metal. In simple terms, Bitcoins are currencies which are intangible and are not issued by the Central Bank. They are generated by a specific community and are definite mediums of exchange in those communities which accept the same. In its judgement the court stated that:

It is not regulated by a central bank or any other form of governmental authority; instead, the supply of Bitcoins is based on an algorithm which structures a decentralized peer-to-peer transaction system.” 

The legality of Bitcoins was discussed elaborately in the same case. The point taken into consideration was whether Bitcoins are securities.

This question was answered in the affirmative by the Court. In this case Shavers, the founder of Bitcoin Saving & Trust (BTCST) solicited the sale of Bitcoins to investors. The investors suffered losses due to a fraudulent transactions and misrepresentations. The first question the Court considered was whether Bitcoins are securities under 15 U.S.C. § 77b. Determination of this issue was relevant to assess whether the SEC had subject matter jurisdiction over the dispute.

Shavers contended that a Bitcoin is not a currency regulated in the United States of America. Further no ‘money’ had been exchanged in these transactions. Therefore SEC does not have the jurisdiction. The SEC on the other hand argued that the BTCST investments are both investment contracts and notes, and, thus, are securities.

The term “security” is defined as “any note, stock, treasury stock, security future, security-based swap, bond…[or] investment contract…” [1] An investment  contract is any contract, transaction, or scheme involving (1) an investment of money, (2) in a  common enterprise, (3) with the expectation that profits will be derived from the efforts of the  promoter or a third party.[2]

By relying on the above definition, the court concluded that a Bitcoin can be used as money as it can be used to purchase goods or services. The only limitation being that the same is used only in places where the currency is accepted. Therefore Bitcoin was held to be security.

While the SEC has at least preliminarily found to have standing to regulate Bitcoins, the Treasury has declined from exercising jurisdiction in relation to investments and trading in  Bitcoins.

 In subsequent posts, we will discuss in detail the regulatory issues out of use and trade of Bitcoins and similar currency with a special focus on India.

[1] 15 U.S.C. § 77b.
[2] SEC v. W.J. Howey& Co., 328 U.S. 293, 298-99 (1946); Long v. Shultz Cattle Co, 881 F.2d 129, 132 (1989).

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